Executive Compensation, Firm Performance, and Mitigation of Agency Theory Effects

1. Executive Compensation, Firm Performance, and Mitigation of Agency Theory Effects Presented by: Michael Music

2. Agenda • Introduction • What is agency theory? • Examples of worst performing CEOs • Extrinsic ways to mitigate agency theory’s effects • Intrinsic ways to mitigate agency theory’s effects • Conclusion: lessons learned • References

3. Introduction • The purpose of a business is shareholder wealth maximization. • Legitimately make profit. • Increase market share price. • Agency theory (principal-agent theory) have historically shown negative influence on firm performance.

4. What is Agency Theory? What is agency theory? • Divergence of owner (principal) and delegated management (agent) interests. • Agent’s actions oftentimes different than principal’s expectations or best interest.

5. What is Agency Theory? (cont.) What is agency theory’s side effects? • Executives rewarded for good luck • Not penalized for bad luck (Garvey & Milbourn, 2006). • Agent’s actions may result in: • Share dilution / decreased market share price. • Increased leverage position. • Decreased capital spending. • Deteriorated profitability.

6. Examples of the Worst CEOs “Nothing succeeds like failure” Author unknown

7. Kenneth Lay - Enron • Quintessential fraudulent executive. • Indicted on July 7, 2004 for Enron catastrophe. • Prior to indictment, estimated net worth $40M. • During trial, Lay claimed net worth was ($250k). • 20,000 employees lost jobs.

8. Enron’s Market Share Price http://ca.encarta.msn.com/media_701610605/the_fall_of_enron_stock.html

9. Robert Nardelli – Home Depot • Amassed approx. $500M in six-year tenure. • January 3, 2007 received $210M severance “golden parachute” (part of $500M). • Meanwhile, investors saw minimal improvement in share price. • Now CEO of Chrysler LLC.

10. Extrinsic Ways to Mitigate Agency Theory’s Effects

11. Extrinsic Ways to Mitigate Agency Theory’s Effects • Stringent use of accounting measures in annual long-term performance plans. • Cash flow, EPS, net income. • Pro: Executive focus on operational excellence. • Con: Performance measures need to be independently evaluated (ext. auditor).

12. Extrinsic Ways to Mitigate Agency Theory’s Effects (cont.) • Incorporate accounting reporting contingency for timeliness and accuracy. • Pro: Executive won’t receive bonus is accounting periods are restated. • Con: May lead to prolonged accounting irregularities over executive tenure.

13. Extrinsic Ways to Mitigate Agency Theory’s Effects (cont.) • Board of directors should evaluate overall company performance (qualitative and quantitative) and the executive’s impact. • Pro: Qualitative measures such as customer satisfaction, market share and product quality can be assessed. • Con: Certain qualitative measures may be difficult to evaluate.

14. Extrinsic Ways to Mitigate Agency Theory’s Effects (cont.) • Implement a target ownership plan with a retention period. • May require executives to hold 50%-75% of shares obtained through exercised options. • Pro: Goal alignment between principal and agent. • Con: Executive plans may become obsessive and promote bad media coverage.

15. Extrinsic Ways to Mitigate Agency Theory’s Effects (cont.) • Board of directors implement rigorous target bonus plan. • Ensure target calculations, methodologies, and metrics are agreed at onset. • Pro: Increased focus on key objectives. • Con: Research suggests corporations have failed to revise performance standards year-over-year (Indjejikian & Nanda, 2002).

16. Intrinsic Ways to Mitigate Agency Theory’s Effects “Beyond money…”

17. Intrinsic Ways to Mitigate Agency Theory’s Effects • Theory suggests personal happiness is primary motivational driver (McConvill (2006). • Personal happiness is enhanced by doing what is best for the company. • Pro: Some executives view money as a means to an end, that end is personal happiness. • Con: Not all executives take this approach.

18. Intrinsic Ways to Mitigate Agency Theory’s Effects • Executives deem their work a calling or “labor of love.” • Pro: Individuals with a calling see their work as contributing to the greater good. • Con: Executives could merely have a sense of achievement – found with prestige.

19. Intrinsic Ways to Mitigate Agency Theory’s Effects • Trust cultivation within a corporation can lead to enhanced company performance. • Pro: Targeted internal executive motivations promote trust within organization. • Con: Mere trust requires a long duration to establish.

20. Conclusion – Lessons Learned • With proper BOD due diligence, agency theory’s effects on firm performance can be mitigated. • A hybrid approach, utilizing both intrinsic and extrinsic approaches is recommended. • BOD should continue to monitor the overall cost of executive compensation at a macro level (in addition to how their company will be perceived).

21. References • Anabtawi, I. (2005). Explaining pay without performance: the tournament alternative. Emory Law Journal, 54, 1558-1602. • Gutner, T. (2005). Explaining the gaps between mandate and performance: agency theory and World Bank environmental reform. Global Environmental Politics, 5 (2), 10-37. • Herzberg, F. (1987). One more time: how do you motivate employees? Harvard Business Review, Sept-Oct, 2-16. • Langbert, M. (1990). In search of compensation: a comparison of executives in Peters and Waterman’s excellent and Fortune’s least admired firms. Benefits Quarterly, 6 (2), 23-36.

22. References (cont.) • McConvill, J. (2006). Executive compensation and corporate governance: rising above the “pay-for-performance” principle. American Business Law Journal, 43 (2), 413-438. • Swinford, D. N. (2006). Essentials for avoiding overcompensating. Financial Executive, 9, 36-38. • Bebchuk, L., & Fried, J. (2005). Pay without performance: overview of the issues. Journal of Applied Corporate Finance, 17 (4), 8-23. • Core, J., & Larcker, D. (2002). Performance consequences of mandatory increases in executive stock ownership. Journal of Financial Economics, 317-340.

23. References (cont.) • Croker, K., & Slemrod, J. (2007). The economics of earnings manipulation and managerial compensation. RAND Journal of Economics, 38 (3), 698-713. • Garvey, G., & Milbourn, T. (2006). Asymmetric benchmarking in compensation: executives are rewarded for good luck but not penalized for bad. Journal of Financial Economics, 82, 197-225. • Indjejikian, R.J., & Nanda, D. (2002). Executive target bonuses and what they imply about performance standards. The Accounting Review, 77 (4), 793-819. • John, K., & Qian, Y. (2003). Incentive features in CEO compensation in the banking industry. Economic Policy Review – Federal Reserve Bank of New York, 9 (1), 109-121.

24. References (cont.) • Kraft, K., & Niederprum, A. (1999). Determinants of management compensation with risk-averse agents and dispersed ownership of the firm. Journal of Economic Behavior and Organization, 40, 17-27. • Morgan, A., & Poulsen, A. (2001). Linking pay to performance—compensation proposals in the S&P 500. Journal of Financial Economics, 62, 489-523. • Rajan, R.G., & Wulf, J. (2006). Are perks purely managerial excess? Journal of Financial Economics, 79, 1-33. • Sloof, R., & Mirjam van Praag, C. (2008). Performance measurement, expectancy and agency theory: an experimental study. Journal of Economic Behavior & Organization, 67, 794-809.

25. References (cont.) • Bhattacharyya, N., Mawani, A., & Morrill C. (2008). Dividend payout and executive compensation: theory and evidence. Accounting and Finance, 48, 521-541. • Core, J., Guay, W., & Thomas, R. (2005). Is U.S. CEO compensation inefficient pay without performance? Michigan Law Review, 103, 1142-1185. • Buck, T., Bruce, A., Main, B.G.M, & Udueni, H. (2003). Long term incentive plans, executive pay and UK company performance. Journal of Management Studies, 40 (7), 1709-1727. • Bruce, A., Skovoroda, R., Fattorusso, J., & Buck, T. (2007). Executive bonus and firm performance in the UK. Long Range Planning, 40, 280-294.

26. Questions?